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1 Lecture 17: General bank management Mishkin Ch 9 – part A page 219-229.

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Presentation on theme: "1 Lecture 17: General bank management Mishkin Ch 9 – part A page 219-229."— Presentation transcript:

1 1 Lecture 17: General bank management Mishkin Ch 9 – part A page

2 2 Outline The bank balance sheet money How do banks get funds and use funds. T-accounts business How do banks operate? Bank management risk Manage risk to be within proper limits.

3 3 The bank balance sheet Balance sheet of a bank is a listing of its assets, its liabilities and bank capital. Assets: what the bank owns, uses of funds Liabilities what the bank owes to others, sources of funds Bank capital Banks net worth, defined to be the difference between its assets and its liabilities

4 4 Assets = Liabilities + Bank Capital

5 5 Liabilities Liabilities are a bank's sources of funds, it specifies what the bank owes to others. 1. Checkable Deposits: checking accounts, etc. liquid, payable on demand, decline in importance 2. Nontransaction Deposits: interest-bearing savings accounts and time deposits (e.g. CDs). the primary source of bank funds. 3. Borrowings: loans obtained from the Fed (discount loans), other banks (in overnight Fed funds market), corporations, etc. an increasingly important source of bank funds.

6 6 Bank capital net worth raised by selling new equity (stocks) or from retained earnings a cushion from insolvency

7 7 Assets Bank assets indicate use of bank funds. 1. Reserves: vault cash + deposits in an account at the Fed required reserves + excess reserves 2. Cash in the process of collection 3. Deposits at other banks are cash items only 4%

8 8 Assets – contd 4. Securities: not allowed to hold stocks, they hold debt instruments (bonds) short-term U.S. government bonds are "secondary reserves" 5. Loans: relatively illiquid, greater default risk primary profit source for banks 6. Other Assets: physical assets, etc are income-earning assets

9 9 T - account Bank performs asset transformations. borrows short and lends long Use T-account to keep track of banks business. T-account is a simplified balance sheet, that lists only the changes that occur in balance sheet items starting from some initial balance sheet position.

10 10 Example 1 - cash deposit Opening of a checking account leads to an increase in the banks reserves equal to the increase in checkable deposits. First National Bank AssetsLiabilities Vault Cash +$100Checkable deposits +$100 First National Bank AssetsLiabilities Reserves+$100Checkable deposits +$100

11 11 Example 2 - check deposit First National Bank AssetsLiabilities Reserves+$100Checkable deposits +$100 First National Bank AssetsLiabilities Cash items in process of collection +$100Checkable deposits +$100 Second National Bank AssetsLiabilities Reserves-$100Checkable deposits -$100

12 12 Example 3 - making a profit Asset transformation: selling liabilities (e.g. checkable deposits) with one set of characteristics and using the proceeds to buy assets (e.g. loans) with a different set of characteristics The bank borrows short (e.g. checkable deposits) and lends long (e.g. loans) First National Bank AssetsLiabilities Required reserves +$10Checkable deposits +$100 Loans+$90

13 13 Bank Management 1. Liquidity Management enough cash and liquidity assets to pay depositors 2. Asset Management diversifying investment 3. Liability Management low cost of getting funds 4. Capital Adequacy Management get enough bank capital as required by regulators manage credit risk manage interest-rate risk manage risks in off-balance-sheet activities

14 14 Liquidity management Banks need to have sufficient reserves or liquid asset to meet obligations to depositors – satisfy their withdrawals. Too much? Too little?

15 15 Ample excess reserves Bank AssetsLiabilities Reserves$10MDeposits$90M Loans$80MBank Capital $10M Securities$10M Suppose required reserve ratio is 10%, for $100 deposit, how much required reserve should the bank have? ample excess reserves deposit outflow (e.g. $10M) bank doesnt need to take actions. Bank AssetsLiabilities Reserves$20MDeposits$100M Loans$80MBank Capital $10M Securities$10M

16 16 No excess reserves Reserves are a legal requirement and the shortfall must be eliminated (bank needs to take actions – it has 4 options – all costly). Excess reserves are insurance against the costs associated with deposit outflows Bank AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital $10M Securities$10MSecurities$10M

17 17 Option 1: borrow from the Fed Borrowing from the Fed incurs cost of interest payments based on the discount rate. Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrow from Fed$9M Securities$10MBank Capital$10M

18 18 Option 2: borrow from other banks If borrow temporarily (overnight), cost incurred is the interest rate (the fed funds market rate) paid on the borrowed funds. Long-term loans cost much more. Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

19 19 Option 3: sell securities The cost of selling securities is the brokerage and other transaction costs, and may incur capital loss. Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

20 20 Option 4: Call in or sell off loans Reduction of loans is the most costly way of acquiring reserves. Calling in loans antagonizes customers. Other banks may only agree to purchase loans at a substantial discount. Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

21 21 Liquidity management Conclusion: Excess reserves are insurance against the costs associated with deposit outflows. Another insurance is holding liquid assets, mainly the secondary reserves - short-term U.S. government securities.

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